When Virtual Crises Turn Real

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Inside the banking offices of Ginko Financial, an eerie crisis has developed. A collection of almost impossibly strapping men and buxom women, along with various furry creatures with wagging tails, crowd around a cash machine. But no cash can be drawn, and the teller windows are empty.

“The threat [of fraud] is thereÂ [but] in Second Life, it just so happens that we know everything that happens.”— Avatar of John Zdanowski, CFO of Linden Lab

This is one of the virtual banks in the “online universe” of Second Life, a fast-growing computer simulation designed by San Francisco–based Linden Lab. The virtual world runs on “Linden dollars,” which the lab currently provides at the rate of L$270 for every real dollar. And more than $20 million worth of Lindens changed hands in the last quarter, making Second Life serious business.

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For those stuck in real life, Second Life is populated by account holders who design “avatars,” characters that can resemble their real-life personae (or not, depending on what the subscriber desires). These avatars interact in many ways, including through commerce. And many account holders seem intent on getting rich in Linden dollars, and thus in real-world money as well. Starting an account is free, although for a charge the avatar can be endowed with any number of special enhancements to make it more attractive in the online world. (Some choose to make their avatars animals, or “furries,” in the jargon of Second Life.) Using purchased Linden dollars, subscribers buy private islands or other land, and create businesses, including banks and even stock exchanges — anything that can be used for fun or profit in Linden dollars and therefore in real money. Last year an avatar became the first to earn $1 million worth of the local currency.

But as Second Life has grown in size and complexity since going live in 2003, many are seeing the need for regulation to protect against fraud, money laundering, tax evasion, and other scams. How should such financial regulation work, though? Such schemes are only some of the “virtual criminality” that threatens to overflow into real-world lawbreaking. Second Life also has concerns about avatars stealing from or otherwise harming other avatars, and most recently a controversy over imaginary-sex software has spurred a lawsuit.

Linden Lab tries to stay above the fray, allowing what it considers a natural experiment to play out and develop. But when it made a foray into regulation last month by banning gambling to comply with local laws, the user backlash and subsequent financial crisis showed that regulation of virtual worlds must be handled with care. And now experts from the real world are beginning to weigh in on issues involving what Second Lifers call “in-world” affairs.

“These things have languished below the radar screen,” says Steve Prentice, chief of research at Gartner, a technology consultancy. “They were probably viewed by regulators as games. But as they grow, there’s a greater understanding that they’re not games.”

“A Full-Blown Panic”
The Ginko crash demonstrates how risky Second Life markets can be — for virtual investors and potentially for Second Life itself. Many users who chat feverishly in online forums have argued that Ginko was a Ponzi scheme all along, offering ridiculous returns and paying them with other investors’ money. Last Thursday the bank posted a note on its Website acknowledging that its coffers of Linden dollars were empty. A wave of withdrawals led to a “full-blown panic depleting even our last line of cash reserves,” wrote Andre Sanchez, the real-world individual whose avatar is Ginko’s CEO. Now the bank is handing out cheap bonds and asking customers to hold tight until it recovers. Ginko owes upward of $750,000 (yes, real dollars), and some customers who invested heavily — hoping to reap whopping 48 percent annual returns — lost as much as $10,000.

The bank’s collapse came as the Second Life economy was stalling. Users started logging off when they could no longer play poker, baccarat, or slot machines. Banning gambling, which represented up to 15 percent of the Second Life economy, led to a drop-off in usage among Second Life’s nearly 9 million registered “residents,” John Zdanowski, chief financial officer at Linden Lab, told CFO.com in an interview. This was compounded when an avatar staged a heist at Second Life’s World Stock Exchange, an equity market of in-world companies. When an ex-employee of the avatar-run exchange used inside knowledge to steal deposits, several newly listed companies were scared off and users saw how their investments could quickly vanish in a world without regulations.

“There are not regulations because the real world already has regulations and laws,” said Zdanowski, who also runs the Second Life economy. “It’s the responsibility of every individual to make sure they’re complying with their own laws.”

But the medium is kept very open by design to attract users and to encourage innovation. Gartner recently warned that real companies setting up shop in Second Life and other virtual worlds put their brands at risk. Companies from IBM and Wells Fargo to Microsoft, Coca-Cola, and Best Buy have all bought real estate in Second Life, thinking they could attract attention, boost their brands, and benefit from a new advertising “space.” Many, however, have since closed their virtual offices, finding such a Wild West environment too unpredictable and insecure. An anonymous world where anything goes can seem risky for real-world corporations. “It’s all pure acts of faith,” says Robert Freedman, who is writing a book about Second Life business strategies to be published by McGraw-Hill. “There’s no one to be held accountable if something goes wrong.”

Earlier this year in Britain, the Fraud Advisory Panel and the Institute of Chartered Accountants warned that Second Life was rife with risks of credit-card fraud, money laundering, and identity theft, and could even be used by real-life terrorists to mobilize funds or to plan attacks. With $20 million worth of Lindens being exchanged in the second quarter and more than 45,000 profitable Second Life businesses, criminal activities could be hard to track amid the chaos.

Linden Lab, a private company founded in 1999, resists becoming a nanny state. The health and happiness of its avatars do not affect its business. But it has nothing to gain by allowing crime in its world — Second Life servers are housed in the United States, and it must comply with those laws.

Benjamin Duranske, an intellectual-property lawyer who writes Virtually Blind, a blog about legal issues affecting virtual worlds, says the fallout from the recent financial crises will likely attract the attention of regulators and encourage users to desire more transparency. “Regulation is inevitable,” he argues. “It’s inconceivable that the Securities and Exchange Commission is not going to pay attention to the fact that someone is running a stock exchange and that something that looks an awful lot like money is changing hands on it.”

Thus far, financial regulators in this country have kept their distance. Asked about the potential for criminal activity within virtual worlds, John Nester, an SEC spokesman, was unaware of how such crimes would work. “While we are charged by Congress with administering the U.S. securities laws, the prospect of having an avatar spokesman to answer questions like this is very enticing,” he told CFO.com. The SEC, he says, presides over U.S. securities markets.

Naturally Selecting a Regulator
The SEC may get its wish. A virtual counterpart to America’s securities regulator appears to be evolving among a group of avatars: the Second Life Exchange Commission is currently in the process of crafting the Second Life Securities Exchange Act of 2007, which, according to its Website, will closely resemble real securities law. Representatives of the SLEC could not be reached for comment, but according to its online mission statement, the supervisory body will be dedicated to “assisting in providing market stability and investor confidence.”

Although virtual worlds may seem to be a regulatory nightmare, they do offer researchers a remarkable laboratory for investigating how markets react to different rules or none at all. Robert Bloomfield, an accounting professor at Cornell University’s Johnson School of Management, has spent much of the summer inside Second Life watching how financial regulation evolves organically. Beyond the SLEC, users are also forming a Second Life version of the Better Business Bureau (BBB). The groups are trying to agree on what practices to promote.

“Whatever regulations do arise have to be more like mutually-agreed-upon best practices,” says Bloomfield. “Firms that get SLEC approval will enjoy a lower cost of capital.” But in rapidly changing virtual worlds, the lack of true oversight erodes trust in would-be regulators. Some owners of skeptical avatars have said the new BBB is extortionist, unfairly blacklisting some firms. Others have condemned the SLEC for being closely tied to one of the big stock exchanges. According to Duranske, the same people starting the SLEC also run the stock exchanges. But ultimately, the final say comes from the creators.

Executives at Linden Lab hold many of their meetings in Second Life, enjoying digital face time and the new addition of voice capabilities that allow far-flung shareholders to communicate avatar-to-avatar. CFO Zdanowski, whose avatar is called Zee Linden, says he spends 10 to 15 business hours per week in-world. He manages the exchange rate with a peg to the U.S. dollar and pumps out additional Linden dollars as needed. What’s more, every transaction made within Second Life can be watched and tracked, while big ones are automatically flagged. The company also puts limits on how much users can buy and sell in one day, based on their in-world experience, to stifle potentially illegal transactions.

Real-world regulators may be largely ignoring virtual worlds because it is unclear what there is to regulate. Do virtual currencies, islands, and buildings have real value? Although they are in demand within Second Life, Zdanowski explains that such assets really just function as intellectual property. As of this month, 9,541 islands have been bought, according to Second Life’s Website; users who spend about $1,675 (the green ones) to purchase one are actually just renting space on Linden Lab servers.

What they do on those islands is up to them, but Linden Lab has certain advantages that agencies such as the SEC do not when fighting fraud. “The threat is there, the danger is there,” says Zdanowski, who serves as CFO, central banker, and, in effect, chief regulator. “The reality is that unlike the real world, in Second Life it just so happens that we know everything that happens.”